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BT shares, which trade in the US as ADRs (BT Group plc), have declined by more than 45% in less than a year. Around half of that descent was confined to a single day last month (Jan 23) when the company announced accounting improprieties associated with its Italy-based operations. The company also noted that some senior management personnel may have embezzled funds. UK’s parent BT shares have shed more than 8 billion pounds because of this accounting scandal.

Italian prosecutors have initiated their own investigation into BT Italia’s accounting fraud. BT Group Plc has been hit by at least two shareholder lawsuits in the U.S. A number of other US law firms specializing in shareholder class action suits are considering filing lawsuits against the company and senior management.

British Telecommunications (BT)

BT Group plc is a holding company which owns British Telecommunications plc, a British multinational telecommunications services company with head offices in London. The company has operations in around 180 countries. The company’s shares are among the most widely owned stocks in the UK. The ownership of BT shares is widely dispersed ̶ about 700,000 of its 827,000 shareholders own 1,600 or fewer shares of the company.

BT ADRs

American depositary receipts (ADRs) were introduced in 1927 as an easier way for U.S. investors to purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs as it makes it easier to attract American investors. ADRs are negotiable certificates issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange.

ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and holders of ADRs realize any dividends and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are also sold OTC.

Italian Job

The fraudulent transactions related to BT-Italy emerged sometime during the summer of 2016 following an internal probe into its Italian business after a “whistleblower” flagged concerns. A whistleblower is an employee who discloses information about illegal acts, mismanagement, abuse of power, or general wrongdoing occurring in the company. If the company is publicly traded and subject to the filing requirements of the Securities and Exchange Commission, whistleblowers are protected by law from retaliation in the US. Some of the major US companies perpetrating accounting fraud were caught and brought to justice by their own employees (e.g., Enron, Freddie Mac, Madoff).

Upon investigation, BT discovered “inappropriate management behavior” within the Italian division. The expected cost of the rent extraction initiated by the Italian subsidiary was estimated to be around £145 million. Sometime in January this year, just days prior to the announcement of the third-quarter results, the company released a statement declaring that, according to an independent investigation by the Big 4 accounting firm KPMG, the losses to BT from the accounting irregularities related to Italian operations were being reassessed at £530m, which is almost 4 times larger than the previously estimated number.

The company suspended several BT Italy’s senior management team. BT has also appointed a new chief executive of BT Italy who took charge of Italy’s operations from Feb. 1.

Telecom Blues

What remains troubling is why wasn’t the accounting irregularity detected by UK’s parent company much earlier. Nick Rose, the chairman of the BT’s audit committee, flagged internal-control issues in Italy in every annual report since May 2013. Yet, the persistent accounting fraud was not detected until 3 years later. By blaming BT-Italy for all the current problems, the CEO of BT may be attempting to distance the parent company, and himself, from the Italian operations by censuring a few perpetrators.

What is even more worrisome is why didn’t the auditors detect this size of an accounting fraud earlier? Independent auditors are expected to provide an assurance that the financial statement are free of material misstatements. One would agree a misstatement exceeding $600 million is material.

Who was BT’s independent auditor? The answer is PwC, which a Big 4 global accounting giant. PwC has been BT’s auditor for the last 30-year since 1984. It is unclear whether BT intends to end its business relationship with PwC. The big accounting firms are renowned for rendering high audit quality so this type of an accounting fraud is likely to a huge set-back for PwC.

Moody’s has warned it may cut BT’s credit ratings. Analysts are skeptical whether the company can afford to maintain a 10 percent growth in its dividend.

Brixmor Property Group Inc., the country’s largest owner of grocery-anchored shopping malls, disclosed that its key personnel were directly involved in “smoothing income” items between reporting periods in quarters dating back to 2013. The changes amounted to $500,000 for 2014 and $300,000 for 2015. A spokesperson for the company said Reuters “We have zero tolerance for unethical behavior at the companies we invest in. While the dollar amounts involved were small, the principle is not. Fortunately, the business remains solid,”

Following the announcement of accounting fraud, Brixmor disclosed that its CEO, President and Chief Financial Officer, Chief Accounting Officer, and an accounting employee had resigned. These related announcements sent the stock price of the company plummeting by more than 25%.

Company Background

Brixmor Property Group Inc., (NYSE: BRX), is a real estate investment trust that is headquartered in New York City. The company owns and operates the largest wholly owned portfolio of grocery-anchored community and neighborhood shopping centers in the U.S., with more than 520 commercial real estate properties located across 38 states. The company’s shopping centers feature grocers, retailers and local retail brands. Brixmor was taken public in 2013 by Blackstone Group, which remains its largest shareholder.

As of 2014, Moody’s assigned Brixmor a Baa3 credit rating, which the company intends to use to acquire new sources of capital in unsecured credit market.

Why “Smooth” Income

My own research (see Ghosh, Gu and Jain, Review of Accounting Studies 2005), and those of others (see, Barth, Elliott and Finn, Journal of Accounting Research 1999), show that investors reward companies handsomely for reporting sustained increases in earnings over consecutive quarters. When companies are able to meet or beat prior period benchmarks, which include prior period earnings or analyst expectations, investors consider earnings to be of high quality, i.e., earnings are expected to persist into the future. High quality of earnings also indicates lower risk because earnings are perceived as being less volatile. Both arguments suggest a surge in stock price.

Think of General Electric (GE) under Jack Welsh. As of fiscal year 2000, GE had reported 100 consecutive quarters of increased earnings from continuing operations. During the 90s decade (1990 to 2000), GE stock price had increased from around $5 to $60 (on an adjusted basis), which is a staggering 1,200% growth (or a 25% growth in stock price per annum).

Why the Decline in Stock Price

One explanation could be that the company might have to restate its prior period financial statement from the accounting fraud. However, this is not the case. The company reported that it does not expect to restate its financial results because impact of the accounting manipulation was immaterial to its performance. Further, the company believes that it will not impact the Company’s compliance with the financial covenants in its debt agreements.

A more realistic explanation is that the company will now become the target of several class-action lawsuits for violating federal securities laws by issuing misleading information to investors. For example, Hagens Berman Sobol Shapiro LLP, a national investor-rights law firm, is investigating whether to file a class action lawsuit based on the current information. Similarly, Scott and Scott, Attorneys at Law, LLP, a global investor rights law firm, is also investigating Brixmor for possible securities fraud.

Past studies show that the amount of settlements from class action lawsuits are economically large – a cost which is ultimately borne by investors!